By Matheus Zani
In late October last year, Lula da Silva won an impressive – if incredibly narrow – election victory that returned him to the Brazilian presidency for his third term. The 78 year old, who had previously governed for two consecutive terms between 2003 and 2010, was ushered in on a wave of social justice and eco-friendly promises with the leftist’s victory putting an end to four years of Jair Bolsonaro’s far-right administration.
For international investors concerned with environmental, social and government (ESG) issues, Lula’s victory in Latin America’s biggest economy (and the 11th largest in the world) was welcome news. Over the course of Bolsonaro’s tenure, many were put off by his disregard for ESG matters and/or felt it left them exposed to criticism from shareholders and activists. This was not the case for all investors, many of whom found Bolsonaro’s strong economic fundamentals, high interest rates and the pro-market stance of his Friedmanite finance minister, Paulo Guedes, particularly appealing. And while Bolsonaro’s approach to the Amazon left a lot to be desired, green energy investment soared under the former leader.
So what now for ESG-minded Foreign Direct Investment (FDI) in Brazil? Following his victory, President Lula had been expected to advance reforms aimed at promoting sustainable investment in Brazil. To date, the concrete details of many of those reforms are yet to be announced. There have, however, been some changes that have indicated which way the wind is blowing. A number of eco-friendly funds, new carbon credit and ESG fund legislation and an immediate drop in deforestation all suggest that Lula’s eco-credentials are more than just hot air.
The Context
The current investment and macroeconomic situation in Brazil
In 2022, FDI reached $90.6 billion, the highest annual figure in a decade. This has continued into 2023: FDI posted its best January in five years, with the country’s central bank attributing the success to improved domestic economic activity, better profitability of companies, the resumption of pandemic-delayed projects and higher demand for investments in energy, technology, and oil and gas.
Despite this, the nation’s wider domestic economic troubles mean it remains a tricky investment landscape to navigate. Public sector debt is currently at an all-time high, amounting to nearly 80% of GDP. The tax burden on the economy is historically high and far exceeds the average for emerging markets, while public investments remain drastically low. This unfavorable state of affairs has been aggravated by the low investment and low productivity of recent years, leading to a lower potential GDP. Despite inflation beginning to decline at the start of the year, the central bank’s benchmark interest rate remains at 13.75%. As a result, many investors are tending to look at government bonds over private investment.
The state of the real (BRL), however, has presented overseas investors with opportunities to increase their returns. Despite recently regaining some strength, in the last year, the currency is down over 7% against USD and 30% since the start of the pandemic.
Getting a grip on the domestic economy is Lula’s main priority. Faced with rising prices and a pandemic-hit labor market that has been slow to recover, many Brazilians are understandably more preoccupied with feeding their families than deforestation. If the reversal of his predecessors' less environmentally friendly policies hinders economic growth any further, Lula could be in trouble – especially with those in the center-right who joined his narrowly-winning coalition.
What route this stabilization will take is yet to be seen. Despite very public arguments with his own central bank, interest rates remain high for now, although they are expected to decline later in the year. Further to this, Lula has promised to revive the South American trade bloc, Mercosur. While his proposed common currency is unlikely to materialize anytime soon, it may serve to boost a Mercosur-EU free trade deal, which could give the bloc much needed investment.
Compared to other developing countries, Brazil is seen as relatively stable and free of geopolitical risks but a renewed sense of stabilization is still a priority for many investors that we have spoken to. With the regime still in its infancy, it’s hard to predict what shape Lula’s Brazil is going to take from an ESG and broader investment perspective. What is certain is that unlike his predecessor, Lula sees the environment as a conduit rather than a blocker to overseas investment and domestic growth.
FDI and ESG sitrep
Ahead of the election, analysis by the website Carbon Brief suggested that a Lula victory could result in an annual decrease in Amazon deforestation by nearly 90% by the end of the decade. For investors put off by Bolsonaro’s deforestation efforts, this was great news. During his tenure, many stayed clear of Brazil or sought to mitigate ESG risks at great cost even in the absence of any requirement to do so.
While on the campaign trail, Lula promised to crack down on illegal mining and bring forest loss under control just as he did during his first presidency. From an environmental perspective, the initial signs are good. Among his first actions after taking office, Lula signed decrees reinstating the governing board of the Bolsonaro-scrapped Amazon Fund and re-establishing Brazil's strategies to reduce Amazon deforestation. He also revoked policies that had diluted environmental protection, including a measure that encouraged mining on protected indigenous lands. In his first month in charge, deforestation fell. However, according to Reuters interviews with current and former government officials, the world is unlikely to see much real progress in the battle to defend the Amazon until 2024 at the earliest.
From a genuine FDI point of view, however, most of these changes are more reputational than anything else. That is, investing in Brazil is now perceived to be more ESG-positive. Clearly it is still very early days but in reality, Lula has struggled to implement many of his promised changes or to attract investment to support them. Other than a few notable exceptions, the ESG investment environment from a legislative perspective remains more or less the same.
Green investment on the rise
Despite being referred to as ‘Captain Chainsaw’, Bolsonaro oversaw plenty of green investment as president with many of the country’s largest eco-infrastructure projects kicking off during his tenure. Between 2016 and 2022, foreign investors announced green hydrogen projects worth $6.1bn. While oil giants BP, Equinor and Royal Dutch Shell and renewables specialists Qair Group and Iberdrola are among the contenders in state-run auctions, initiated under Bolsonaro, to build offshore wind turbines along Brazil's 7,400km Atlantic coastline.
And while there have been a number of eco-infrastructure investments since Lula took office, with projects of this size it seems investors are relatively unconcerned with who is in power as long as there is a semblance of stability. In January 2023, one of the world’s biggest privately-owned renewables companies, Cubico Sustainable Investments, announced the purchase of Brazil’s 1GW Project Sobral from ZEG Energias Renováveis. Upon announcing the purchase, Cubico’s Head of Latin America Francisco Moya Reina spoke for many overseas investors when he said: “We are a long-term investor so we’re going to be here for 30 to 40 years. In the lifetime of the project, we’re going to see different governments in power[...] the main challenge now is inflation.”
Overseas ESG funds are already taking shape
Where there has been a clear shift is in the creation of a number of funds set up to aid Brazil’s environmental goals. The most notable of these being the Amazon fund. The fund was originally set up by Lula in his most recent presidency in 2008 to receive international contributions to Brazil's efforts to stop deforestation before being paused by Bolsonaro in 2019. Norway, one of the original fund’s biggest contributors until it cut funding in response to Bolsonaro’s policies, has stated that it is ready to bring back the fund which still holds over $600m. However, Brazil's efforts to get the European Union, Britain, France and Spain to contribute have yet to pan out.
In March, it was also reported that Brazil and China were in talks over a green investment fund.
Sweeping Brazilian fund changes have ESG in mind
There have also been changes to the Brazilian funds industry via CVM Resolution No.175. The legislation’s key function is to open up Brazil’s already impressive domestic fund market to overseas retail investors. In the past, only domestic investors and a select group of overseas institutional investors had access. However, within that were interesting tweaks around ESG. When the changes come into effect in October 2023, investors will now be able to purchase and trade carbon credits, whilst investment funds that wish to label themselves as ESG funds must meet minimum criteria to prove they are genuinely making a positive social and environmental impact.
The changes were initially set to be introduced in April but have been pushed back to October to give fund managers and administrators time to prepare.
The Investment Risk Perspective
Foreign Exchange Risk
Historically, the BRL is the most volatile currency in the region and is particularly subject to fluctuations against major international currencies such as USD and the euro (EUR). The pandemic hit BRL hard and as such, many USD investors have had opportunities to make low-cost investments in Brazil. However, BRL has strengthened more than 6% since the collapse of Silicon Valley Bank and as of April 2023 is at around 4.9 per dollar, its strongest level in more than a year.
Ongoing disagreements between Lula and the central bank around credit conditions mean these gains remain at risk. Overall though, for the time being, BRL remains a cheap currency with the potential to gain further if the macro fundamentals — including easing fiscal and policy uncertainty — continue to improve.
Market Risk
Brazil's private equity (PE) landscape has experienced a period of turbulence, marked by a decline in the number of active firms, diminishing dry powder, and an increasing concentration of available capital among a select few managers. Amidst these challenges, the PE managers who have persisted are those boasting high returns relative to their competitors and the ability to adapt to the evolving market by exploring opportunities in technology investments.
With the contraction of the Brazilian PE industry, there are now potentially more opportunities than available capital to support them. As a result, experienced managers may find themselves in a prime position to capitalize on the reduced competition. By carefully selecting the best deals and securing lower entry multiples, these managers could replicate the exceptional returns generated during the early phase of Brazil's PE industry between 1998 and 2002, a time when there were only a handful of active PE managers.
It’s too early to say if Lula’s presidency will lead to more ESG-friendly opportunities. However, as we’ve pointed out, despite the Bolsonaro regime’s hostility to climate change, the Brazilian economy has been welcoming to green private investment for a while now.
Inflation Risk
While the central bank has kept interest rates at 13.5%, Brazil's inflation has been decreasing which has resulted in the highest inflation-adjusted rate in the world— at least double that of Mexico, the next-highest real rate for a major currency.
However, the view among most analysts is that inflation will rise again. According to Brazil’s central bank, over 70% of analysts predict inflation could end the year as high as 6.26%, up from 5.9% in March. If Brazilian inflation goes above its 3.25% target (with a tolerance band of 1.75% to 4.75%) for the year, it will be the third year in a row inflation has exceeded the upper limit and the fifth year in a row it has risen above the target.
All Eyes On the Economy
There’s no doubt that Lula is saying all the right things when it comes to ESG. This, in and of itself, is a boost to ESG-minded investors. However, other than the Amazon Fund and legislative changes for overseas retail investors, we’re yet to see any significant changes in how ESG investment differs in Lula’s Brazil. In fact, many of the biggest investments in Brazil’s green industries started prior to his victory.
This doesn’t mean that change isn’t coming. Attracting the FDI Lula needs to help boost Brazil’s sluggish economy requires having ESG policies in place that appeal to foreign investors. And given Brazil’s largely commodities- and resource-dependent economy, increasing sustainability in those sectors will arguably attract further international investment. If he is able to succeed in increasing that sustainability, ESG investment opportunities will surely arrive. Brazil’s unique PE situation also means overseas investors will be able to more easily capitalize on these opportunities as and when they emerge.
For many investors, regardless of their feelings on ESG issues, attention now turns to how Lula is able to make his mark on Brazil economically. Progress is being made on that front. In April, proposals were submitted for a new fiscal framework aimed at taming public spending and debt. The announcements saw Brazil's benchmark stock index rise 1.5% and the Real hit a nearly two-month high against USD. The biggest positive, however, is that it seems, to some degree at least, to have united Lula’s government with the central bank. Despite not knowing the details of the new framework, Central bank President Roberto Campo Neto told journalists the early proposals he heard seemed "quite reasonable."
Over to you, Lula.
